The Global Economy in Retrospect:
A Brief Economic History from 1945 to 2017
In July 1944, a total of 44 delegates from the allied countries convened for a world conference at the Mount Washington Hotel in Bretton Woods, New Hampshire. The objective of the Bretton Woods Conference was to establish an integrated international system that allowed countries to pursue domestic policies aimed at promoting full employment. The principal architects of the new system were John Maynard Keynes and Harry Dexter White. The conference addressed the de-globalization that had become the world order in the years between World War I and World War II. This was a period of world-wide depression and nationalism: the passage in 1930 of the Smoot-Hawley Tariff Act, leading to an increase in import duties to as high as 60%, the replacement of the gold standard of fixed exchange rates with a fragmented system of floating exchange rates, and the United States’ refusal to be an international lender of last resort.
In the Bretton Woods Agreement that emerged from the conference, signatory nations agreed to a system of fixed but adjustable exchange rates. Deficit countries were required to intervene in the foreign currency market to stop their currency from depreciating by buying it with their international reserve holdings (central bank holdings of gold and currency). For the system to function, countries would need to have a sufficient amount of international reserves. To ensure adequate reserves, the International Monetary Fund (IMF) was created. The IMF worked like a banking system, in which each country contributed capital based on their proportion of world trade, and created a fund from which central banks could borrow currency to support their exchange rates.
The Bretton Woods fixed exchange-rate system also created the need for countries to impose capital controls. In the 1950s and early 1960s, New York was the most accessible market for corporations to raise capital. As a result, many foreign companies issued dollar-denominated bonds in the United States. The popularity of the Yankee bond market began to decline when the U.S. government imposed the Interest Equalization Tax on foreign securities purchased by U.S. investors.
The tax was aimed at reducing the interest rate differences between higher-yielding foreign bonds and lower-yielding U.S. bonds—a difference that U.S. investors could take advantage of given the fixed exchange rates. Predictably, it led to a decline in the Yankee bond market. However, it also contributed to the later development of the Eurobond market as more foreign borrowers began selling dollar-denominated bonds outside the United States. The Interest Equalization Tax was repealed in 1974.
Following the Bretton Woods Agreement, in Geneva, on October 30, 1947, 23 nations signed the General Agreement on Tariffs and Trade (GATT)—a multilateral agreement committed to the promotion of free trade through multilateral trade negotiations. By 1993, 123 countries, covering over 90% of the world’s trade, were signatories of the GATT. The Agreement was based on the acceptance of the most-favored nation principle, the reduction of tariffs and non-tariff trade barriers (dumping, quotas, and export subsidies), and consultation among nations in solving trade disputes within the GATT framework.
GATT’s initial success in promoting globalization was limited by U.S. protection policies that were in effect during the 1950s which prevented the President from negotiating any tariff reduction that would damage a U.S. industry. In 1962, the U.S. Congress passed the Trade Expansion Act that authorized the President to negotiate across-the-board tariff reductions of up to 50% of their 1962 levels. The Act also provided trade adjustment assistance in the form of retraining workers and providing tax relief and low-interest loans to firms injured by tariff reductions. Under the authority of this Act, the U.S. negotiated the Kennedy Round of multilateral trade negotiations in 1967. The Kennedy Round of trade negotiations led to a reduction in the average tariffs on developed countries to less than 10%. GATT lasted until the World Trade Organization (WTO) was established in 1995. GATT led to nine multilateral-trade rounds that reduced tariffs and non-tariff barriers (Exhibit 1).
The Trade Expansion Act marked a seminal departure from nationalism. Upon signing the Act on October 11, 1962, President Kennedy said:
Energy Prices and Stagflation
Nobel Laureate Paul Samuelson described an economic state in which both inflation and recession are present as stagflation. In the 1970s, the U.S. and other industrial economies experienced severe stagflation resulting from increases in energy prices. Specifically, the price of OPEC oil increased from $1.67 per barrel in 1970 to approximately $31.00 per barrel in 1980. The growth in energy prices inflated overall production costs and lowered economic growth rates for energy consuming countries. The U.S. suffered recessions in 1974, 1975, and 1980, with each of the recessions accompanied by surges in the rate of inflation. Over the decade, the annual inflation rate averaged over 10%, whereas the growth rate in real GDP was only 5% (by contrast from 1982 to 1995, real aggregate output doubled). During this period, there was also a significant rise in interest rates in the U.S. and other industrial countries. The rise in interest rates precipitated decreased levels of aggregate investment expenditures to the point where the U.S. was not making the necessary investments needed in its manufacturing facilities (steel plants, automobile facilities, etc.) to maintain its production advantages.
Collapse of Bretton Woods
When a country has a balance of payments deficit (surplus), the deficit (surplus) has three economic impacts: (1) The money supply decreases as local currency is used to purchase foreign currency (foreign currency increases for a surplus), (2) the price of foreign currency increases (decreases for a surplus), and (3) international reserves decrease (increase for a surplus). Under the Bretton Woods fixed exchange-rate system, a deficit country was required to intervene in the currency market to stop its exchange rate from increasing by using its international reserve holdings. The equilibrium adjustment worked through changes in the money supply and international reserves. This system, though, led to persistent external imbalances amongst countries that had inconsistent stabilization policies. For example, a deficit country fighting unemployment with expansionary monetary policy or fiscal policy found its policies offsetting the normal monetary contraction and balance of payments correction resulting from the deficit. These countries would eventually run out of international reserves needed to maintain the system. This was the case in the United States and Great Britain, and it led to both countries devaluing their currency in 1972 and 1973. In both devaluations, the countries allowed their exchange rates to be determined in the foreign currency market. In 1973, the United States announced that they would no longer support their currency, thus marking the collapse of the fixed exchange-rate system and the de facto move to the flexible exchange-rate system.
The term “Strategic Trade Policy” refers to government policies that promote activist trade and protectionism. The Policy is based on the argument that a nation can create a comparative advantage in trade through temporary trade protections, subsidies, tax benefits, and cooperative programs between the government and businesses in industries deemed important to the future growth of the nation. During the 1950s, 60s, and 70s, many of the larger developing countries adopted import-substitution strategies for industrialization. Countries such as India, Pakistan, and Argentina protected infant industries with tariffs and other protection tools. In contrast, countries such as Hong Kong, Korea and Singapore stressed an export-oriented strategy for industrialization.
For Japan and Europe, strategic trade policy often involved dumping. In the 1970s, Japan was accused of dumping steel and television sets and Europe of dumping cars and steel in the United States. Another form of dumping was export subsidies. Many developed countries provided foreign buyers of a nation’s exports, low-interest loans to finance their purchase. In the U.S., the U.S. Export-Import Bank was financing about 2% of U.S. exports with such loans, with the proportions higher in Japan, France, and Germany. The U.S. Foreign Sales Corporation Provision of the U.S. Tax Code, in turn, provided partial exemption on taxes from income earned on exports from the foreign subsidies of U.S. companies. Over 3,600 U.S. corporations took advantage of this provision, including Boeing, Microsoft, and IBM. In the 1980s, Japan’s Ministry of Trade and Industry targeted the development of the semi-conductor industry, which was dominated by the U.S. The Ministry provided tax exemptions, fostered cooperative government-industry initiatives, and provided the industry with trade protections.
The Tokyo Round that concluded in 1979 led to a reduction in the average tariff of 31% for the U.S., 27% for European countries, and 28% for Japan. However, the Tokyo Round was not successful in securing an agreement to reduce non-tariff barriers. In 1985, and later in 1987, the U.S. filed anti-dumping suits against Japanese computer chip exporters, charging continuous dumping of chips and imposing a 100% duty on Japanese chip exporters. In 1991, the tariff was removed when Japan agreed to help foreign and U.S. producers to increase their share of the Japanese chip market from 8% to 20%—the “Semiconductor Agreement.” In 1999, the World Trade Organization ruled that the U.S. Foreign Sales Corporation Provision was a form of an export subsidy and ordered the U.S. to repeal the provision.
Eurocurrency and Eurobond Markets
In the 1950s, the Soviet Union maintained large dollar deposits in U.S. banks in order to participate in world trade. However, poor political relations, as well as U.S. financial claims on the Soviet Union originating from the Lend‑Lease Policy, led to the Soviet Union fearing that the U.S. government could expropriate their deposits. As a result, the U.S.S.R., with the aid of some U.S. banks, transferred their dollar deposits to banks in Paris and London, thus creating the first modern-day Eurodollar deposit. Subsequently, the increase in international trade, the rise of multinationals, the emergence of the dollar as an international reserve currency under the Bretton Wood's exchange rate system, and the policy of some governments to maintain dollar deposits led to a substantial increase in Eurodollar deposits abroad in the 1960s.
During the early 1960s, most of the Eurodollar deposits were in foreign banks that, in turn, used the deposits to make dollar loans to many U.S. companies directly competing with U.S. banks. In 1963, there were few U.S. banks with foreign operations in Europe. The U.S. banks that did operate there did so mainly to facilitate their corporate customers' international business. In the mid-1960s, though, U.S. banks began to go after Eurodollar deposits and loans by establishing foreign subsidiaries. What brought the American banks to Europe en masse was probably not so much the loss of business to European banks as it was the opportunity to work around Federal Reserve regulations. Specifically, with lower or no reserve requirements and no regulations governing the maximum rates payable on time deposits, U.S. banks, by offering Eurodollar deposits and loans, were able to offer their customers better rates on loans and higher rates on time deposits. By 1969, roughly forty American banks with branches abroad were lending approximately $14 billion in Eurodollars. This market, despite a crisis in 1973, grew to a $270 billion market in 1974. By the 1980s, the Eurodollar market had become the second largest market in the world, extending beyond Europe and intermediating in currencies other than the dollar. Accordingly, the market gave rise to the offshore banking centers in places such as Nassau, Singapore, Luxembourg, and Kuwait. These areas had less restrictive banking laws and thus became a place for intermediation between both foreign lenders and foreign borrowers.
A Eurobond is a bond issued outside the country in whose currency it is denominated. For example, P&G issuing a bond denominated in U.S. dollars throughout Europe. In the 1970s and 1980s, the market for Eurobonds began to grow. The market benefited in the 1970s from a U.S. foreign withholding tax that imposed a 30% tax on interest payments made by U.S. firms to foreign investors. However, there was a tax treaty that exempted the withholding tax on interest payments from any Netherlands Antilles subsidiary of a U.S. incorporated company to non-U.S. investors. This tax treaty led to many U.S. firms issuing dollar-denominated bonds in the Eurobond market through financial subsidiaries in the Netherlands Antilles. During this time, Germany also imposed a withholding tax on German DM-denominated bonds held by non-residents. Even though the U.S. and other countries with withholding taxes granted tax credits to their residents when they paid foreign taxes on income from foreign security holdings, the tax treatments were not always equivalent. In addition, many tax-free investors, such as pension funds, could not take advantage of the credit (or could, but only after complying with costly filing regulations). As a result, during the 1970s and early 1980s, Eurobonds were often more attractive to foreign investors and borrowers than foreign bonds. The growth of the Eurobond market, as well as the Eurodollar market, was also aided in the late 1970s by the investments of oil-exporting countries that had large dollar surpluses. From 1963 to 1984, the Eurobond market grew from a $75 million market with a total of seven Eurobond issues to an $80 billion market with issuers that included major corporations, supranationals, and governments.
Contractionary Monetary Policy and 21% Prime Rates
Beginning in October of 1979 and extending through October 1982, the Federal Reserve, under the governorship of Paul Volcker, raised the discount rate, increased reserve requirements, and set lower monetary growth targets for its open market operations. This contractionary monetary policy was aimed at combating the U.S.'s high inflation and increasing capital inflows to address the country’s balance of payments issues. These actions represented a directional change in the Federal Reserve’s policies from the preceding three-year period in which they maintained lower discount rates and reserve requirements. Although higher energy prices had already contributed to inflation and higher interest rates, these contractionary monetary actions served in pushing rates even higher. By 1982, yields on 10-year Treasury notes were over 13%, mortgage rates were 15%, the prime lending rate charged by banks was 21%, and the Dow Jones Average was at 800 and the S&P 500 was at 140. This precipitated another recession with real GDP declining by 1.9% in 1982 and U.S. unemployment rising to 9.7% from its 7.2% level only two years earlier.
Reagan Fiscal Policy Stimulants, Monetary Easing, and Lower Energy Prices
Since the late 1960s, fiscal policy in the U.S. has been characterized by deficit spending in which federal government spending exceeded tax revenues every year with only three exceptions. The Reagan Administration in the 1980s increased government expenditures and substantially cut taxes. These expansionary fiscal policy actions were accompanied with an accommodating monetary policy by the Federal Reserve. The combined expansionary monetary and fiscal policy actions led to the U.S.'s economic recovery during the second half of the 1980s and lowered interest rates. 10-year Treasury yields dropped from 13.01% in 1982 to 7.67% in 1986. Real GDP grew 7.3% in 1984 and 4.2% in 1985, while the unemployment rate fell from 9.7% in 1982 to 7% in 1986. Inflation declined from a high of 13.3% at the end of 1979, to 3.9% in 1984, and then 1.1% in 1986. However, the U.S.’s deficit increased from $80 billion to $221 billion in 1986, with public debt increasing to 47% of GDP in 1986.
The higher energy prices of the 1970s also encouraged greater world oil exploration, the development of alternative energy sources, and the implementation of energy conservation policies. By the mid-1980s, a worldwide oil surplus had developed and began weighing down on energy prices. In contrast to the 1970s and 1980s, energy prices were relatively stable for most of the 1990s. For the period from 1983 to 2004, the average price of crude oil was $22.61, with the range between $10.40 (3/31/1986) and $37.05 (6/31/2004).
Supply-Side Economic Growth
From 1984 to 2000, U.S. GDP rose from $4 trillion to over $10 trillion, and the stock market, as measured by the S&P 500, increased over 690%, going from 167 in 1984 to 1,320 by the turn of the century. While some of this extraordinary growth can be explained by the expansionary monetary and fiscal policies of the mid-1980s, the decrease in energy prices, and world economic growth, a significant amount of this growth is also attributed to scientific and technological advances in areas such as computers, genetic engineering, and telecommunications. The advances in technology and science that were realized in the 1990s (though their development was much earlier) increased the productivity of labor and capital. As a result, for much of the 1990s the U.S. and other industrial economies enjoyed not only significant economic growth, but also stable prices. During this period, interest rates in the United States trended down as seen with the 10-year U.S. treasury yield declining from 10.6% in 1985 to 6.03% in 2000. For the same period, the unemployment rate fell from 7.2% to 4.0%.
The Rise of Economic Integration
The early post-war period saw the beginnings of economic integration. The European Union was formed by the Treaty of Paris in 1951 and then the Treaty of Rome in 1957. Initially called the European Common Market, its membership consisted of West Germany, France, Italy, the Netherlands, and Luxembourg. The European Common Market featured a common external tariff, free trade amongst members, common prices for agricultural goods, and less restrictive barriers to labor and capital movements. In 1973, the United Kingdom, Denmark, and Ireland joined the European Union. Greece, in turn, joined in 1981, followed by Spain and Portugal in 1986, and Austria, Finland, and Sweden in 1995. By 2000, the European Free Trade Association (EFTA), which had been formed by many of the countries not in the EU, was left with only four members: Switzerland, Norway, Iceland, and Liechtenstein.
In 1993, the EU removed all remaining restrictions on the free flow of labor and capital, making them the single largest trading bloc. The trading bloc also adopted a common value-added tax system and provided government subsidies to agricultural products, as well as to Airbus and Concorde. The EU moved closer to a full economic union—the highest form of economic integration—in 1992 with the Maastricht Treaty. The treaty established the timeline for the creation and implementation of the European Economic and Monetary Union (EMU), which included all EU members except for the United Kingdom and Denmark, which had opted not to join. In 1998, the European Central Bank was created and exchange rates between member currencies were fixed; a prelude to the creation of the euro currency. In 2002, each EMU member forfeited control over their monetary policies, and the euro began circulating.
By all accounts, the EU increased competition. Many smaller companies grew, realizing the benefits from economies of scale. The EU also led to a growth in foreign direct investment with multinational companies setting up production facilities within the EU to avoid discriminatory trade barriers imposed on non-member products—tariff factories.
In September 1993, the United States, Canada, and Mexico signed the North American Free Trade Agreement (NAFTA). The agreement created free trade over North America and reduced barriers to cross-border investments. With wages six times higher in the U.S. than in Mexico, free trade access to Mexico allowed U.S. industries to import labor-intensive components from Mexico. NAFTA benefited Mexico by increasing its access to the U.S. market and facilitating more foreign direct investment into Mexico; which resulted in export-led growth for the country. Unlike in the EU, NAFTA did not preclude its members from signing their own free trade agreement with other countries. The U.S. signed free trade agreements with Israel in 1965, Jordan in 2001, Singapore in 2003, Chile in 2003, Australia in 2004, Morocco in 2004, and with the Central American Common Market in 2004.
Efforts at economic integration were only slightly successful in the rest of the world. The Central American Common Market (CACM) of Costa Rica, El Salvador, Guatemala, Honduras, Nicaragua, and Santa Domingo was established in 1960, dissolved in 1969, and revived again in 1990. The Southern Common Market (Mercosur) of Argentina, Brazil, Paraguay, and Uruguay was established in 1991, became part of the CACM in 1999 and then negotiated a free trade agreement with the EU.
The Collapse of the Soviet Union and Privatization
After the collapse of the Soviet Union in 1989, the 12 Central and Eastern European Countries (CEEC) as well as the 15 Newly Independent States (NIS) of the former Soviet Union faced the challenge of restructuring their economies. This involved freeing prices and wages from government control, transferring ownership of resources from the government to private entities—privatization, opening their economies to competition and trade, and establishing the legal and institutional framework for a market economy (property rights, banking, financial markets, accounting standards, and business laws). Since 1989, Poland, Hungary, the Czech and Slovak Republics, Slovenia, and Estonia have made substantial progress in restructuring their economies. The other CEEC countries, like Russia, and most of the NIS nations, lagged behind in reforms and have struggled with unemployment, inflation, government deficits, and international deficits. In May 2003, 10 former communist-bloc countries joined the EU: Poland, Hungary, the Czech Republic, the Slovak Republic, Slovenia, Estonia, Lithuania, Latvia, Malta, and Cyprus.
The Emergence of China
According to many experts, the Third Plenary Session of the 11th Central Committee of the Communist Party in December 1978 was the seminal event that changed China from an unsteady and often stagnant economy, into the world’s second largest. The plan that emerged from the session called for higher growth rates in both industry and agriculture, identifying 120 construction projects that would require massive investment expenditures and foreign technology. By 1985, China was on course, having created a significant number of modern textile mills, steel plants, chemical fertilizer plants, petrochemical facilities, and smaller manufacturing facilities for producing consumer goods. Foreign trade had accelerated, now accounting for 20% of China’s GDP, and its industrial sector produced more than 46% of its GDP using 17% of the country’s labor force.
In 1990, China’s leader Deng Xiaoping pronounced at the 14th National Communist Party Congress that China's plan for the decade was to create a "socialist market economy." During the 1990s, growth continued to accelerate with the introduction of more than 2,000 special economic zones (SEZs) and the inflow of foreign direct investment. In 1996, the Chinese economy was growing at a 9.5% rate and was accompanied by low levels of inflation. By 1999, according to some sources, China had become the second largest economy in the world, trailing the United States. For the period 1990-2004, China's economy grew at an average annual rate of 10%—the highest growth rate in the world. In 1990, China had reopened the Shanghai stock exchange, and then in December of 2001, China became a member of the World Trade Organization.
Growing exports was an important part of China’s economic plan. By 2006, its total trade balance surpassed $1.76 trillion, making it the world's third largest trading nation after the U.S. and Germany. To maintain its export growth, China depreciated their currency by investing a significant amount of its international currency reserves (U.S. dollars) resulting from its balance of payment surpluses in U.S. treasuries, and through its sovereign-wealth funds, in foreign assets.
The Uruguay Round
In 1993, the Uruguay Round of multilateral trade negotiations began with 123 countries participating. The objectives of the Round were to curb non-tariff trade restrictions, establish rules for the protection of intellectual property rights, and bring services, agriculture, and foreign investments into trade negotiations. This 8th round of trade negotiations took seven years to complete, and led to agreements covering tariff reductions, the removal of tariffs on pharmaceuticals and medical equipment, and established protection periods on patents, trademarks, and copyrights.
S&L, Banking and Sovereign Debt Crises
In the second half of the twentieth century, many countries experienced significant economic growth. This growth, though, followed a pattern of peaks and troughs. Economists have debated the cause of the business cycle. In his classic 1939 work, Joseph Schumpeter, the Austrian Economist, argued that fluctuations were the result of overshooting. Overshooting, in turn, is frequently the result of the behavior of the financial markets during different economic periods. When an economy is expanding, financial institutions are more liberal in extending credit and increasing loans, governments often ease regulatory restrictions, and investors tend to buy more securities. This in turn results in more loans, investments, and ultimately the overproduction of goods and overpriced assets. By contrast, when an economy is receding, financial institutions tend to tighten credit and limit their loans, governments often tighten regulatory restrictions, and businesses and households tend to curb their investments; this results in underproduction and underpriced asset values. Thus banks, financial institutions, and investors through their lending and investing behaviors, tend to exacerbate a current economic trend, which leads to an overshooting of that trend. The period from 1980-2000 saw a banking and savings and loans financial crisis in the U.S. and sovereign debt crises in Latin America, Russia, and East Asia. These crises all followed a similar pattern: increased credit precipitates a lending and investment boom, which is followed by a slowdown in the economy that leads to massive loan losses and the resulting debt crisis, whose climax comes in the form of government bailouts and new laws and regulations.
In 1980, the U.S. Congress passed the Monetary Control Act. The Act deregulated the U.S. banking and S&L industry by extending the uses of funds of thrift institutions, eliminating Regulation Q, imposing uniformed reserve requirements, and increasing deposit insurance coverage. The Act served to make the banking and financial industry more competitive. With high interest rates in early 1980, this more competitive financial environment resulted in many thrift institutions offering higher rates to keep customers and then investing those funds in riskier investments to maintain their spreads. Moreover, with the lack of a regulatory apparatus to monitor thrifts, many so-called Zombie S&Ls (insolvent S&Ls still operating) surfaced taking on risky investments and attracting deposits away from more fundamentally sound S&Ls. For example, in 1984 Charles Keating acquired Lincoln S&L. He immediately replaced Lincoln's conservative lending board and plunged the firm into risky investments in junk bonds, currency futures, and stocks. He also made illegal real estate loans to American Continental—his own development company. Lincoln avoided any serious bank and thrift examination until 1986. When the U.S. economy slowed in the late 1980s, many of Lincoln’s risky investments failed, which led to the company’s $1.6 billion collapse. At the end of 1980, there were 750 insolvent S&Ls in the United States. The crisis prompted the passage of President Bush's Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FERREA). This Act placed all deposit insurance for thrifts and banks under the FDIC, set up the Resolution Trust Company to take control of the insolvent S&Ls, and restored restrictions on S&L assets, limiting their investments in risky securities and commercial real estate.
Like S&L’s, U.S. banks also sought out new but riskier investments during this period. By the late 1980s, banks were failing at a rate of 200 per year. In 1991, Congress passed the Federal Deposit Insurance Corporation Improvement Act, reaffirmed the “Too-Big-to-Fail” doctrine, and established more stringent reporting and examination processes.
During the high oil price period of the 1970s, oil producing countries such as Brazil, Argentina, and Mexico borrowed huge sums of money from the World Bank and large money-center banks for industrialization and infrastructure programs. In these countries, external debt grew from $75 billion in 1975 to more than $315 billion in 1983. With oil prices declining in the early 1980s, though, these Latin American countries were unable to generate earnings to cover the cost of their debt. Mexico’s sovereign debt crisis surfaced in 1982, when their Minister of Finance declared that they would no longer be able to service their debt. Debt crises also surfaced in Venezuela in 1994, East Asia in 1994, Mexico again in 1995, and Russia in 1998.
Direct Investment and the Global Financial Market
With the opening up of China, India, and other developing countries, along with technological advances, the period from the mid-1990s to 2007 saw the meteoric rise in foreign direct investment. By 2005, multinationals accounted for about 25% of world output, channeling international capital flows and developing a global supply chain.
This period also saw the globalization of security exchanges, the growth in existing exchanges in emerging markets such as China, India, and Brazil, and the consolidation of existing ones through mergers and alliances. From 1995 to 2007 Germany’s three exchanges merged into the Frankfurt exchange, then consolidated with London and Paris exchanges, and finally in 2007 joined the NYSE to form the transatlantic NYSE Euronext. Such consolidation was the result of technology and the emergence of electronic trading systems that today can handle 10,000 stocks as easily as 200. Consolidation also widened the market for global investments, provided access to traders worldwide, and created 24-hour trading.
By 2000 the Eurodollar market had evolved into the Eurocurrency and Asiandollar markets. Governments and multinationals used the market to deposit currencies and to obtain loans to finance business assets, government infrastructure, and external deficits. In 1984, the U.S. and Germany rescinded their withholding tax laws on foreign investments, which spurred the growth of the Eurobond market. From 1984 to 1998, the Eurobond market grew from $80 billion to $1.4 trillion. By 2001, Eurobonds had become an important source of intermediate and long-term financing of multinationals, sovereign governments, and supranationals (e.g., the World Bank). Russia, for example, raised $4 billion in 1997 through the sale of Eurobonds. In 2010, 80% of new issues in the international bond market were Eurobonds.
Securitization and Hedge Funds
One of the most innovative developments to occur in finance over the last three decades has been the securitization of assets. Securitization involves creating a new security backed by a large number of assets (e.g., residential and commercial mortgages, auto loans, home equity loans, and credit card receivables) that have been grouped into a pool. A trustee, such as a financial institution or government agency, often holds the pool of assets that serve as the collateral for the new securities. The new securities are then sold to investors as asset-backed securities (ABS).
Up until the mid-seventies, most mortgages originated when savings and loans, commercial banks, and other thrifts borrowed funds or used their deposits to provide mortgage loans, possibly later selling the resulting instruments in the secondary market to Fannie Mae, Freddie Mae, or Ginnie Mae. To a large degree, residential real estate until then was financed by individual deposits, with little financing coming from institutional investors such as insurance companies and trusts or from investment funds. In an effort to attract institutional investors’ funds away from corporate bonds and other securities, as well as to minimize their poor hedge, financial institutions began selling mortgage-backed securities. Over time, these securities were structured in different ways to make them more attractive to different types of investors. By 2007, MBS and ABS were among the most popular securities held by institutional investors, competing with many different types of bonds for inclusion in the portfolio of institutional investors.
The securitization process, creating prepayment tranches like PACs and credit tranches like senior-subordinate structures, and the structuring of ABS for credit cards, home equity loans, receivables, and other assets, all pointed to the innovativeness that characterized the financial industry. These innovations revolutionized the way real estate, accounts receivable, car loans, and other assets were financed.
The 1990s also witnessed the growth of lightly unregulated hedge funds. By 2007, there were over 4,000 such funds. Many of these funds took derivative positions or were highly leveraged, with debt-to-equity ratios as high as 20 to 1.
Overshooting, Corrections, and the Global Financial Crisis
From 2000 to 2006, expansionary U.S. monetary actions, the uncontrolled expansion of derivatives and securitization, and the liberal credit policies of financial institutions led to excessive overshooting, especially in the housing industry. Prior to 2000, most potential homebuyers who did not meet strict qualification standards were denied loans. As a result, most mortgages were considered prime. In 2000, the Mortgage Bankers Association estimated that 70% of all loans were prime conventional, 20% were FHA-insured loans, 8% were VA-insured, and 2% were subprime. With the combination of the growth in securitization, the push by Congress to increase home ownership, and the introduction of innovative mortgage loans such as teasers, stretch loans, piggyback loans, and stated income loans, subprime mortgages accelerated from 2000 to 2006. In 2006, the Mortgage Bankers Association still estimated that 70% of all mortgage loans were conventional, but 17% of those were now subprime. As a rule, if property values increase, subprime borrowers are in a position to sell their properties and payoff their loans. Unfortunately, the real estate market, which had been accelerating since 2001, cooled in 2006 when a number of the innovative loans were reset at higher rates that many borrowers could not afford. This led to defaults, bankruptcies, the decline in property values, and ultimately the collapse of the subprime market.
In June 2008, the subprime mortgage meltdown that had started in August of 2007 developed into a global credit crisis. This crisis gained steam throughout the first half of 2008 with the fire sale of Bear Stearns to J.P. Morgan Chase, substantial asset value write-downs by many global financial institutions, and a subsequent panic by these firms to raise billions of dollars in new capital from a variety of sources to repair their balance sheets. By September 2008, asset write-downs exceeded $590 billion. In a dramatic 10-day period from September 7 to September 17, the trillion dollar mortgage giants Fannie Mae and Freddie Mac were placed into conservatorship by the Treasury, Lehman Brothers filed for the largest bankruptcy in American history ($600 billion), and American International Group received an emergency $85 billion lifeline from the Federal Reserve. The subprime mortgage meltdown brought the financial markets down and led to recessions in the U.S. and Europe, and to slower economic growth in China.
Monetary and Fiscal Policies
In an effort to stabilize financial markets, the Federal Reserve cut interest rates from 4.25% at the start of 2008 to 2.00% by June 2008. Central banks around the world took similar actions by also cutting rates. The Federal Reserve also pumped billions of dollars into the banking system via new lending programs. In aggregate, these programs provided over $500 billion in lending capacity to U.S. and foreign financial institutions.
During this period, the Federal Reserve took extraordinary emergency steps by guaranteeing money market funds, backstopping commercial paper programs, coordinating a global interest rate cut with other central banks, making loans to institutions collateralized by mortgage-backed and asset-backed securities, and purchasing such securities as part of their open market operations. Similarly, the Treasury structured the Troubled Asset Relief Program (TARP) to shore up U.S. bank balance sheets with capital injections. The impact of these unprecedented liquidity measures was to increase the Fed’s balance sheet from $850 billion in August to $2.2 trillion in November and to lower rates from their already existing low levels. In fact, short-term Treasury rates were at one point at negative levels, while credit spreads on BBB credits over Treasuries had widened to 7%.
In 2009, real GDP in the U.S. declined by 2.9% from its 2008 level, unemployment was at 9.2%, and the underemployment rate approached 17%. In the EU, real GDP declined by 2%, with the unemployment rate at 9.3%. Starting in 2008, the Obama Administration implemented an expansionary fiscal policy on a scale similar to FDR’s policies in the 1930s. This included government spending increases as part of the $800 billion American Recovery and Reinvestment Act, an increase in direct transfers (food stamps, unemployment insurance, and subsidies to state and local government for Medicaid), and a $600 billion fiscal stimulus that included a two-year payroll-tax reduction. The Obama Administration’s fiscal actions significantly increased the federal government deficit. The deficit went from $459 billion in 2008 to $1.8 trillion in 2009 and to $1.258 trillion in 2010 before declining to $1.089 trillion in 2012. These deficits pushed U.S. public debt from $10.7 trillion in 2008 and to $16.4 trillion in 2012, increasing the percentage of debt to GDP from 73% in 2008 to 100% in 2012.
Slow Economic Growth
In the U.S., the recession technically ended in mid-2009. From 2009 to 2017, U.S. real GDP grew at an annualized rate of just 2.2%. The slow recovery rate from the collapse of the real estate market in the U.S. was consistent with recovery rates from previous financial crises. Normally, recoveries from financial crises, such as Japan’s asset bubble, the 1980’s emerging market crisis, and the 1930’s stock market crash, take longer than so-called “V-shaped” recoveries following cyclical recessions.
From 2009 to 2014, the Fed implemented its quantitative easing policy of keeping short-term rates near zero, injected cash into the financial system, and purchased mortgage-backed securities and debt from FNMA, FHMC, and GNMA. As part of the quantitative easing policy, the Fed began selling short-term securities and purchasing long-term securities—a policy referred to as “Operation Twist.” These monetary actions all served to stabilize the banking industry, lower intermediate rates, support a fragile housing market, and monetize the U.S. government’s debt. Similar monetary and fiscal policy actions were also undertaken in other developed countries in which central banks lowered rates, implemented programs to support banks and guarantee assets, and increased their government budgets with fiscal policy stimuli. The recovery, as described by the Economist (January 9, 2010) was one in which many governments responded to the crisis by taking the debt burden off the private sectors’ balance sheets and putting it on their own. In 2013, the housing market did begin to pick up with new home sales increasing to its highest level since 2008.
During this slow economic recovery, corporate earnings were positive. This was attributed to work force reductions and to lower interest rates that reduced corporate borrowing costs. Firms were also decreasing their capital expenditures. This decrease coupled with their higher earnings resulted in significant increases in corporate cash positions, making many companies net suppliers of funds instead of net users. As of June 2012, the S&P 500 firms had approximately $900 billion of cash, which was 40% higher than their holdings in 2008. In 2012, GE reported that they expected to have $100 billion in cash holdings over the next few years, which they, in turn, estimated would be sufficient to finance their new investments, acquisitions, and share buybacks. Similar phenomena were also occurring in 2012 in other countries, such as Japan, Britain, and Canada, where corporate liquidity holdings had increased. Moreover, because of tax laws, a significant proportion of corporate cash was held outside the United States.
From 2009 to 2013, the EU grew at a rate of only 1%, with Germany, the UK, and France experiencing slow growth, and Greece, Italy, Spain, and Portugal still receding. With its growing dependence on world trade, China grew at a rate of 8.9% in 2011 and 8.4% in 2012. This contrasts with a growth rate of 11.5% in 2007. By 2012, China was facing a growing wealth gap and excessive misinvestment. Like the U.S. and Europe, China launched an economic stimulus plan focused on increasing affordable housing, easing credit restrictions for mortgages, and lowering taxes.
Falling Crude Oil Prices and the Increases in U.S. Energy Production
Following the Gulf Wars, energy prices began to increase. By 2008, crude oil prices were close to $100 per barrel. The higher prices, though, increased energy exploration, the development of alternative energy sources, and a greater adoption of new technologies for extracting energy, such as hydraulic fracturing—fracking. According to the Economist, fracking in the 600-mile Marcellus Shale formation reserve—an area that encompasses Ohio, Pennsyvania, New York, and West Virginia—created over 100,000 jobs in energy and related industries, such as steel. The shale-gas boom also took hold in Texas, Louisinana, Arkansas, and Oklahama, and led to an increase in oil exploration in those states, as well as in North Dakota, where the same technology was applied. The increase in fracking and drilling, in turn, led to significant decreases in domestic gas prices from $13 per million BTUs in 2008 to $2 in 2012. Cheap energy prices, combined with the U.S.’s extensive pipeline network, contributed to lower electric prices, increased exports, greater foreign direct investment, and increased investment in energy-intensive industries, such as liquid fuels, plastics, fertilizers, steel, and chemicals.
The price of crude oil decreased from $105 per barrel in 2015 to $51 in 2017 (Exhibit 2). The decline was due to the higher supply of oil and the actions of OPEC to increase inventories in attempts to drive non-OPEC producers out of the market. This decrease caused a significant drop in rig counts in the U.S. for producers that could not compete at the low-price level.
Even with increased energy production the U.S. economy remained stagnant in 2015. From July 2015 to the beginning of 2016, the dollar appreciated by approximately 13%, making U.S. exports more expensive. According to Deutsche Bank, approximately 40% of S&P 500 companies’ profits came from abroad. In the third quarter of 2015 alone, corporate profits of S&P 500 companies decreased by 3.5%.
The rise in the dollar also burdened foreign corporations and countries with large dollar-denominated debt holdings who were also experiencing declining dollar revenues. From 2004 to 2014, the dollar-denominated debt of developing countries more than doubled from $2 trillion to $4.5 trillion. Companies such as Petrobras and Gazprom, with large dollar-denominated liabilities and falling dollar-denominated revenues, were particularly hurt. As reported in the Economist, even China with its sovereign wealth funds’ large dollar holdings was confronted with almost 25% of its corporate debt being dollar denominated and only 8% of its corporate earnings being in dollars.
Continued Slow Economic Growth
From the beginning of 2013 to the beginning of 2017, the U.S., Europe, and China continued to experience low growth rates. Real GDP in the U.S. grew at a rate of only 2.11% for the period. Unemployment had dropped from 7.5% in 2013 to 4.7%, but wage and personal income growth was flat. The EU also continued to experience stagnant economic growth. The EU unemployment rate had declined from 10.5% in 2013 down to 8%, but personal income was also flat. With the marginally higher interest rates in the U.S., the euro declined against the U.S. dollar from a high of $1.33 in March of 2014 to $1.12 in May 2017. Spain showed signs of economic recovery while Greece continued to struggle, with the IMF leading efforts for a fourth bail out. Finally, China’s growth rate declined to 7%, down from its 2010 levels of 11% and 2007 levels of 15%. China also was facing a local government debt problem resulting from it massive infrastructure misinvestment, declining home sales, which raised concerns of a housing bubble, and a drop in foreign exchange reserves (Exhibit 3).
Signs of De-Globalization: Trump, Brexit, and Euroscepticism
Following the U.S. election of President Donald Trump on November 8, 2016 to the end of the second quarter of 2017, the S&P 500 increased 11.44% from 2,177 to 2,426. This “Trump Bump” reflected investors’ optimism regarding Trump’s fiscal policy proposals for a tax cut, massive infrastructure expenditures, tax concessions to repatriate the estimated $2.6 trillion of corporate cash abroad, and the replacement of the Affordable Care Act. President Trump’s economic proposals paralleled those of the Regan Administration.
The President’s election also signaled the possible return of U.S. protectionism, and with it, the fear of disintegrating the global world order that had evolved since Bretton Woods. Currently, at issue is the future of the global supply chain, NAFTA, trade relations with Mexico, the replacement of multilateral trade agreements with bilateral agreements. President Trump’s election signaled the United States’ move towards nationalism:
The UK’s Brexit referendum vote on June 23, 2016 to exit the EU also signaled Britain’s move towards nationalism. Similarly, after years of economic crises, refugee issues, and Britain’s successful referendum, Euroscepticism is growing in the EU.
There have been three major directional changes in the world economic order since World War II. The period from 1945 to 1973 saw the rapid expansion of advanced countries and the Bretton Woods and GATT agreements move the world towards globalization. This lasted until 1973, when the Bretton Woods system collapsed and high-energy prices led to a period of economic stagflation and the rise of strategic trade policies. The third directional change started in the 1980s when lower energy prices, technological advancements, and globalization led to exponential growth in advanced countries, the emergence of China, and the rise of the global supply chain. This lasted until the 2008 financial crisis and through the ensuing slow economic recovery that followed. With the election of President Trump and the Brexit vote, the world may now be poised for the next big directional change.